Here's Why Orion Engineered Carbons (NYSE:OEC) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Orion Engineered Carbons S.A. (NYSE:OEC) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Orion Engineered Carbons

What Is Orion Engineered Carbons's Debt?

As you can see below, at the end of June 2022, Orion Engineered Carbons had US$882.7m of debt, up from US$710.5m a year ago. Click the image for more detail. However, it also had US$40.9m in cash, and so its net debt is US$841.8m.

A Look At Orion Engineered Carbons' Liabilities

The latest balance sheet data shows that Orion Engineered Carbons had liabilities of US$581.6m due within a year, and liabilities of US$870.7m falling due after that. On the other hand, it had cash of US$40.9m and US$416.5m worth of receivables due within a year. So its liabilities total US$994.9m more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$954.7m, we think shareholders really should watch Orion Engineered Carbons's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Orion Engineered Carbons's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 5.0 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. If Orion Engineered Carbons can keep growing EBIT at last year's rate of 14% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Orion Engineered Carbons can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Orion Engineered Carbons burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We'd go so far as to say Orion Engineered Carbons's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Orion Engineered Carbons's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Orion Engineered Carbons (of which 2 are potentially serious!) you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.